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Friday, April 24, 2009

Boomerang: Government and Systemic Risk

If you’re not careful when throwing a boomerang, it could come around and hit you in the back of the neck. Politicians and bureaucrats should learn the same lesson when touting their supposedly indispensable role in safeguarding the country’s economic security. If you look closely, you find that they are the biggest source of the very dangers they presume to protect us from.

Last month the Treasury announced a “Framework For Regulatory Reform,” which “focuses first on containing systemic risk.” The release said: “While we strengthen prudential oversight for all firms, we must also create higher standards for all systemically important financial firms … to account for the risk that the distress or failure of such a firm could impose on the financial system and the economy.”

The Treasury is not alone in talking about this. Rep. Barney Frank, among others, wants Congress to create a “systemic-risk regulator,” perhaps within the Federal Reserve. Fed chairman Ben Bernanke also sees the need for the government to regulate systemic risk. In a speech to the Council on Foreign Relations in March titled “Financial Reform to Address Systemic Risk,” Bernanke said, “Any firm whose failure would pose a systemic risk must receive especially close supervisory oversight of its risk-taking, risk management and financial condition, and be held to high capital and liquidity standards.”

There is something bizarre, indeed, about government assuming the role of protector against systemic risk. Knowledge problems aside, is there any entity in our society that presents a greater systemic risk than the U.S. government, including the Federal Reserve?

That the central government is systemically risky in the extreme hardly needs demonstration. It borrows trillions of dollars to cover profligate spending, shouldering future generations with heavy debt and taxes. Its tentacles reach into every nook and cranny of the marketplace. Regulation of the critical financial industry is pervasive and has been for years. When rules, such as inflexible capital requirements and cartelized securities-rating procedures, emanate from a central bureaucracy, the financial system is vulnerable to mistakes that the bureaucracy will inevitably commit. Competition is a discovery process, as Hayek taught, which means that a monopoly central regulator deprives the market of important discoveries that would have been made in its absence. Mistakes are thus more likely and the vulnerability of the entire system is magnified.

One need only study the genesis of the current financial crisis for the most recent example. When the federal government imposed housing and lending policies on the market, it set everyone up for the disaster that ensued. Now even people who did not take out mortgages or buy homes are suffering for the policymakers’ mistakes.

The Fed

The biggest single creator of systemic risk is the Federal Reserve. It manages the money supply, and money is part of virtually every transaction that occurs. Its monetary conduct also influences the most important set of prices: interest rates, key signals that coordinate the allocation of scarce resources over time. By tampering with those signals the Fed is in a position to make huge mistakes that can harm everyone–which is exactly what it has done throughout its history.

“Manages the money supply” doesn’t quite capture what the Fed really does. It creates money out of thin air to carry out macroeconomic objectives and, most recently, to bail out firms deemed too big to be permitted to fail.

What could be a bigger systemic risk than a legal counterfeiter whose handiwork is legal tender? Here is a true weapon of mass destruction.

No private bank or other company has ever come close to causing the damage the Fed has caused. Its inflations robbed people of purchasing power while twisting the economy out of shape with artificial booms that inevitably ended in unemployment and other hardship. It was the Fed that gave us the Great Depression and the depression within a depression several years later. The same Fed is at least partly responsible for the late housing boom that has brought so much misery (and expanded government power). And the Fed now multiplies risk by buying up trillions of dollars in toxic bank assets, exposing the people to future crushing tax liabilities and inflation.

Besides creating bigger risks than private firms (without government privileges) could ever create, government agencies also encourage banks and other financial companies to take more risks than they could possibly take in a free market. Any hint that the government will bail out big companies increases the likelihood of reckless behavior on a scale that couldn’t be imagined otherwise. Last month Bernanke said, “[T]he Federal Reserve, other federal regulators, and the Treasury Department have stated that they will take any necessary and appropriate steps to ensure that our banking institutions have the capital and liquidity necessary to function well in even a severe economic downturn. Moreover, we have reiterated the U.S. government’s determination to ensure that systemically important financial institutions continue to be able to meet their commitments.”

What is that if not a invitation to undertake systemically risky conduct in the future?

The idea that the U.S. Treasury, the Federal Reserve, and Barney Frank will save us from systemic risk sounds like a “Saturday Night Live” sketch. For some reason, no one is laughing.

  • Sheldon Richman is the former editor of The Freeman and a contributor to The Concise Encyclopedia of Economics. He is the author of Separating School and State: How to Liberate America's Families and thousands of articles.